Capital Asset Pricing Model
Order Instructions:
please do Part A : 3,4,5 and Part B: 2,3
(total : 5 questions)
SAMPLE ANSWER
PART A
3) The current price of ordinary common shares in Commonwealth Bank (CBA) as at 15/5/2015 was$84.75. The share price of CBA has moved as per the graphical representation and tabular form here below:-
Source: https://www.commbank.com.au/
| Market Prices |
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| F |
Source: http://finance.yahoo.com/q/hp?s=CBA.AX&a=00&b=30&c=2010&d=04&e=15&f=2015&g=m
As can be demonstrated CBA’s price has evolved over the last five years from a low of $54.30 to a high of $84.75 which represented a growth of about 56% over the five years. The huge increase in the bank’s share is attributed to the consisted divided payments as from 2010 to the current period. During each year the bank paid dividends as shown in shown in the table below.
| Prices |
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Source: http://finance.yahoo.com/q/hp?s=CBA.AX&a=00&b=30&c=2010&d=04&e=15&f=2015&g=v
In addition to the fact that the bank has declared dividends each year it is the only financial institution that in 2010 and 2011 appeared in Dream Employers’ Top 20 list. Dream Employers top employers is a survey done on companies in Australia and New Zealand. This implies that the bank is a good employer and as such has motivated and productive employees. The company is one of the four largest banks in Australia. Most investors assume that the bank is too big to fall. The bank’s share price has also been on an upward trend since 2010 which many investors assume is an indicator that the bank will continue to grow and report higher profits.
The bank’s price earnings ratio was 15.94 times in 2015 which implied that investors were willing to pay $15.94 for every dollar of earnings from the bank. This implies that investors are expecting to earn more returns from the bank in future. The bank’s price earnings growth ratio for the last five years was 4.20. When compared with the price earnings ratio is it clear that the bank’s stocks are overvalued in the market
(http://finance.yahoo.com/q?s=cba.ax)
4) a) To calculate the required return the dividend growth model formula is as follows;
Whereby;
Po represents current share price of ordinary share
rs represents required return on ordinary shares and
Do represents dividend per share of the bank
From the information provided
Po =$84.75
D0=2.82857
Rs=?
- 75=2.82857/rs
- 75rs=2.82857
- Rs=2.82857/84.75=0.033
The required rate of return is 3.3%
- b) To calculate the required rate of return Capital Asset Pricing Model is used hereunder.
Capital Asset Pricing Model is used to price securities with a high risk as it describes the relationship that exists between expected or required rate of return and the market risk. It is calculated using the following formula.
The βCBA is 0.92 which is the βa
Source; http://www.investing.com/equities/commonwealth-bank-of-australia
The 10 year Australian Government bonds have a coupon rate of 6% p.a which is the rf
Source: http://www.asx.com.au/products/interest-rate-derivatives/bond-derivatives.htm
Rm is 5% which the equity risk premium
Ra= 6%+0.92(5%-6%)
=>0.06-0.0092=0.0508 or 5.08%
The required rate of return is 5.08%
5) The last dividend of 2.82857 per share was paid on Feb 17, 2015. As at this date the shares were trading at 91.92 cum-dividends. After dividends were paid on Feb 17, 2015, the shares started trading ex-dividend. Investment theory stipulates that the price per share would fall by the size of the divided paid per share in this case the next month trading should have been (91.92-2.82857)=89.09. The share price however went up to 84.30 as at March 2, 2015. There are various reasons as to why the share price did not behave as was theoretically expected. The first reason is the many investors held that Commonwealth Bank is too big to fall and therefore it is less risky to invest in it. Some investors wanted to buy more of that stock since trend analysis show that the share price has been growing which could be construed to mean that the bank would still make more money in future and pay higher dividends. With such an optimistic view on the bank there is no wonder that the share price went up instead of going down.
PART B
2) This involves crossing a direct and indirect Foreign Exchange quotation as follows;
- EUR / USD: 1.1442 / 46
- USD / CHF: 0.9090 / 94
To determine EUR/CHF cross-rate:
- 1442×0.9090=1.0401
- 1446×0.9094=1.0409
EUR/CHF 1.0401-09
The Current EUR/CHF cross rate is 1.0484 which is higher than the rate calculated of EUR/CHF 1.0401-09
The best way to guarantee a risk free profit is by signing forward exchange rate contracts which would ensure that foreign exchange today is used to settle transactions that will occur in future. This contract will ensure that costs and revenues are not affected by adverse fluctuations in foreign currency. A business executive will have to approach a foreign exchange dealer and sign a forward foreign exchange contract to transact at a certain predetermined exchange rate. A savvy business executive would acquire foreign currency and invest it in the market awaiting delivery as per contract terms. Foreign exchange hedging strategies mitigate against the risk of unpredictable fluctuation in exchange rates in the market.
Using the formula for calculating forward points to determine estimate the 3-month EUR/CHF forward rate on 04 December 2014.
The central bank rates show It=0.05% and Ib=0%
Points=> 1.0484+(1+(0.0005*90/365)/(1+(0*90/365)-1)=1.0485
The 3-month forward price EUR/CHF 1.0485 .
When compared to spot rate 3 month later of EUR/CHF 1.0484 it is almost similar. This demonstrates that forward rates are relatively accurate in predicting spot prices in future.
(Sharma, Piyush and Shivam, 2014).
(http://www.xe.com/currencycharts/?from=EUR&to=CHF)
3) The yield on 2-year Swiss government securities as at 03 March 2015 was negative 0.75%. It would be unwise to invest at a negative yield unless the economy is going through a deflation and is severely depressed. This is because government debt instruments are relatively stable in terms of holding money. Otherwise investment in equity stocks would ordinarily yield better returns as well as placing the funds in a fixed deposit account in a bank. Investors may be willing to purchasing such a security if they predict the economy to be depressed and possibly going through a deflation. Otherwise investors would invest in stocks of companies that pay good dividends every year and have strong and sustainable cash flows (Bolger, 2012).
References
Bolger, Piers. 2012. “Does Investing in Fixed Income Still make Sense?” Money Management,
Sep 28. http://search.proquest.com/docview/1081004267?accountid=45049.
http://finance.yahoo.com/q/hp?s=CBA.AX&a=00&b=30&c=2010&d=04&e=15&f=2015&g=v
http://www.asx.com.au/products/interest-rate-derivatives/bond-derivatives.htm
http://www.xe.com/currencycharts/?from=EUR&to=CHF
http://www.investing.com/equities/commonwealth-bank-of-australia
http://finance.yahoo.com/q?s=cba.ax
http://finance.yahoo.com/q/hp?s=CBA.AX&a=00&b=30&c=2010&d=04&e=15&f=2015&g=v
Sharma, Piyush and Shivam Rai. 2014. “THE DETERMINANTS OF FOREIGN EXCHANGE
RATE (FER) VOLATILITY IN THE INDIAN ECONOMY.” Indian Journal of Commerce and Management Studies 5 (3): 34-43. http://search.proquest.com/docview/1561351070?accountid=45049.
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